This is the 2nd part of the study, Please find the 1st part here: 1st Part Link
Dear All, Hope you all are doing great. It has been a long gap since we have shared something at this blog. Actually recently, We have entered full time into Investment advisory services (SEBI IA registration Number INA000020244). Plus, for long time there was a demand from all of my readers to start a learning module which should cover all aspects of Investment world. So we are also starting the same from Mar-2026. Present study is a part of that learning module. In the learning Module we will be covering various topics affecting investment world like Fundamental and financial analysis, Economics, Company law, taxation, Business studies, Geopolitics and behavioural studies. Those who are interested please contact: gurpreet@oscillations.in and oscillationss9@gmail.com (https://oscillations.in).
The present study is about the factors affecting the forces responsible for economic growth/activity which moves in cycles and then world of investment of cyclical firms as to why Cyclical firms are valued as such and whether there is a need to review some factors. I have taken the case of Global shipping industry which is more closely related to global GDP growth and demand supply variables. Here, I have considered two Shipping sector stock (Great Eastern Shipping Company Ltd and Shipping Corporation of India Ltd) for explaining the valuation complexities of a cyclical stock. Please take note that this is not a recommendation for investment. I could have taken a stock of any other cyclical industry for study. It is just that I have considered Shipping sector because of so much of recent activity in this sector due to war and tariff issues.
The study is dividend in two parts- part first (Part A) is about economic cycles and factors/forces responsible for their movement and intensity. Part 2nd (Part B & C) is about factors/forces affecting the global shipping (Indian stocks GE Shipping and SCI in the background). The two parts are only due to size. Part C is about some factors/topics which I have not explained fully; only because of size of this study. I will take up these topics in the next study.
The world of Investment is an Upside Down Tree
Study of Valuation complexities of Cyclical stocks- Case study of Global Shipping Sector considering two Indian Shipping Stocks GE Shipping Ltd and Shipping Corp of India ltd for analysis.
PART-B
Now we are into the Part-B of the study. Part-A has taken some material amount of time which I didn’t plan. So we will try to do fast now. Here, I have taken Indian Shipping sector stocks (Great Eastern Shipping Company Ltd and Shipping Corp of India ltd) for explaining the valuation complexities of a cyclical stock. Please take note that this is not a recommendation for investment. I could have taken a stock of any other cyclical industry for study. It is just that I have considered Shipping sector because of so much of recent activity in this sector due to war and tariff issues. Most importantly, shipping is one cyclical sector influenced by large number of factors most of which are global so it is very difficult for shipping firms (and policy makers) to devise a strategy. But still best shipping firms do possess the ability to execute strategies (and GE Shipping is one such firm from India). So we can see the impact of various factors unfolding on shipping sector.
Some Cyclical stocks are effected more due to business cycles
Some sectors are more effected by business cycles and these are the sectors whose stocks are worst hit in the stock market also. Also, these are the stocks trading at relatively lower valuations. If we can see then every sector is cyclical- some are more while some are less cyclical. Even the most defensive ones like FMCG or healthcare has some amount of cyclicality.
Profits in the business are more related to revenues than cost while the losses are more related to expenses than revenue. And when business cycle turns revenue gets hit. Expenses also get lower but it is not in the same proportion because many expenses are fixed; so very easily we can understand that the ones with higher fixed costs component get more hit during cyclical downturn. And what entails higher fixed cost- Businesses requiring high investment in fixed/physical assets (plant & machinery) which further incur other significant costs associated with fixed assets like interest cost and manpower cost. These businesses which require high investments in fixed assets are the ones effected most during the downturn because they can’t lower their high fixed cost. High fixed costs means relatively higher investment is required to earn every single unit of revenue. For example, cyclical sectors like shipping, Hotel, steel etc. require high investments in fixed assets. Healthcare/hospital is also the one with higher fixed assets investments but it is not cyclical because people generally do not lower or postpone their healthcare requirements so healthcare is a defensive sector.
Usually, the defensive sectors have relatively lower investments in fixed assets. Take for example, FMCG sector where most of the investments is into product development and branding. And once a brand is established and has strong customer loyalty then the business has huge asset turnover ratio and profitability (Stocks like Nestle, Uniliver).
Higher Fixed assets investment means higher depreciation
GE Shipping, during times of up cycle (high profits) still has around 25-30% against Depreciation and Interest costs and during down cycle the same goes up to 50% of the revenues. But comparing with topline is not worthy since different industries have different cost structure like Shipping has lower variable cost because there are no raw materials to work upon. So better approach is to consider operating profit (EBITDA) for comparison.
In shipping, during normal up cycle the depreciation is around 30-40% of the EBITDA but during downcycle it can touch 70% of the EBITDA. If we include interest cost (related to fixed assets) then the same will hit even higher. Similarly, if we see steel industry the depreciation figure is around 20% during up cycle but during down cycle it can hit 40-50% and even higher with interest figure. So if we can see then during down cycle shipping firms incur heavy losses mainly due to higher depreciation (and interest).
But treatment of depreciation in the profit & loss statement is very interesting
If we can see then depreciation is not like any other items of cost. Unlike most of the costs depreciation doesn’t involve outflow of funds in every reporting period. Because fund outflow happens in the year of acquisition of fixed assets so in the subsequent periods there is no fund outflow. Depreciation is just charged into P&L statement as an expense. But do we really need to reconsider its implication on profits? Especially in the case of cyclical industries?. The primary objective behind financial reporting (accounting) is to ascertain the performance of the business in the reporting/accounting period. And the same is achieved by recording/accounting of revenue earned in that period and then matching/alignment of associated expenses to revenues. So we have income which is measured to see the performance of a firm by matching of costs and revenues in the reporting period. Revenue is a timing entity (occurrence of revenue in the reporting period) while matching of costs is the relative (subsequent) part which is about accounting for expenses incurred to earn the revenues.
So we charge depreciation under matching principle as the resource in the form of fixed asset is presumed to be consumed during the reporting period against the revenue earned. The purpose of depreciation is to match the cost of an asset to the revenue it generates over time. But primarily, the objective is to maintain a fund for the replacement of the fixed assets in the future so we can understand the main reason behind depreciation is to preserve the investments in the fixed assets. So what happens is that when we charge depreciation in the P&L account the equivalent amount is accumulated as current assets in the balance sheet. In effect, depreciation reduces the book value of assets but increases the current assets. Usually we don’t see a dedicated item in the balance sheet against depreciation reserve; also there is a chance that the reserve funds can be used to pay the debt or creditors although I am always in favour of keeping the depreciation reserve in the balance sheet invested in liquid assets to account for the fixed asset inflation in the future.
In cyclical industries like Shipping the revenue is lower during the downcycle time and we can understand that the natural wear and tear of the ships in the form of depreciation should have also been lower and some ships may not even be used. So there is a possibility to review the performance of shipping business during down cycle. Present methods of depreciation mainly use straight line method which divides the cost of a ship equally to its estimated useful years (around 20 years tankers and 25 for dry bulk). As we know, depreciation is a fund created by firms to replace assets in the future so that they can “produce” forever. So depreciation is “savings” of the firm to invest in new assets in the future. If we can see, depreciation is the largest part of the total savings of an economy…even bigger than household savings. Household savings are bigger in value but they are not used in entirety for investments in the new productive assets in an economy. But depreciation represents those savings which are used entirely for investments in new assets which are crucial for economic growth. If these investments in new assets are not done then there is no motivation for new technology in an economy. In an economy if depreciation fund is not used for investments then that economy is going to witness economic downturn.
So depreciation is not just an item of expense in the profit & loss account like other expense but it is a fund created to replace old non-useful assets. If a firm is selling its products at prices where it makes losses then this business won’t be able to replace its assets in the future to continue production. So depreciation in this case is Zero because there is no saving. Hence, if we can see depreciation does not increase the losses of the business as is generally perceived; it is a saving for the future out of current profits.
But when our accountants were devising methods to account for depreciation in the books of accounts they did not pay any attention to economic uncertainties like business cycles and inflation. They ignored the highly variable and uncertain environment/market conditions under which managers are required to take crucial business decisions concerning investments in new assets. Like, in shipping during good times firms delay the scrapping of ships on an average for 5 years; thus extending the useful life of ships and profitability. So market conditions are the decisive factor where a manager takes important decisions based on market forces rather than generic/commoditized accounting principles.
As shared above, depreciation being a crucial saving fund for investments in an economy, the same should be treated with care, caution and relevancy. Depreciation, as is claimed, primary motive is to create a fund for the future perpetual existence but if we can see it is because of this depreciation that during the times of depression many shipping firms shut down. The revenue of a firm depends upon the Market forces/conditions like in shipping it is freight rates which are determined by market forces but when we see depreciation which is charged against these market determined revenues the same is based on cost!! So there is a need to review this for shipping firms (and other cyclicals also). We need a new method to depreciate ships and that should take into account the market conditions. In my view, depreciation based on revenue (tonnage transported) should provide a better solution. This will take care of higher depreciation charge (savings) during boom period and lower charge during bust cycle. This will also smooth out the high variability in the performance of shipping firms.
This new depreciation method can be further fine-tuned but that should reflect market conditions because ships are a very different class of business assets. Old ships can be sold or purchased much easily compared to other businesses like steel where it is very complex to sell machinery from an existing plant and building a new ship takes about 2 years. Further, ships account for the major cost component of a shipping firm. But the prices of ships are very dynamic; it is possible that a firm has invested major capital in buying new ships during upcycle (flawed one) so the resultant depreciation is also high or higher number of ships are purchased but most of them are not used. Same is true for down cycle when prices of ships are much lower. It is at that time when more efficient firms invest in acquiring new ships which can be a major factor in future profitability. Like, GE shipping right now is having around Rs. 8000 cr liquid funds accumulated out of depreciation and higher profits during recent upcycle. Its market cap is around Rs. 15000 cr. It has reduced its debt from Rs. 5000 cr five year ago to just Rs. 1200 cr; lowering its annual interest cost from Rs. 500 cr to 100 cr.
So GE Shipping has created a large fund to buy ships cheaply during next downturn. Even during the current good cycle, it is focussing on modernization of its fleet; it is selling its older ships (nearing 20 years age) and buying new younger ones in order to maintain operational efficiency (younger ships have lower operating costs). It is not adding new capacity during the current high price cycle; it has added new capacity during previous downcycles; it added quite a number of new ships in 2017-2019. So if we can see the decision making complexities and the futuristic focus of the managers while navigating the highly variable and uncertain shipping business; they add the excess capacity during the lean periods so that when tide turns they would be able to make the best use of it. But this excess capacity during lean period means higher depreciation charges which impacts the bottom line heavily and this makes the current valuation approach to shipping stocks quite linear and one dimensional. The need is to look at depreciation differently; as a fund, futuristic tool and strategy rather than a plain charge in the Profit & Loss statement. This will make investment fraternity to adjust their valuation process and models.
Global economies and global trade in general are getting less cyclical and a need to review the cyclicality factor impact on valuation multiple
Shipping stocks are the ones who suffer the highest impact of cyclicality factor. Although it is shipping which still carries almost 90% of the global trade. It is only because of shipping that goods and products could have been transported across the globe which is the real factor behind the high growth enjoyed by global economies in the last 100 years. Without shipping humanity must have been very ordinary. Still, in spite of being so valuable to the global trade the valuation multiple of shipping stocks is very ordinary. The reason- impact of business cycles on global trade making it cyclical and thus uncertain. Here, there is no such thing as global GDP because global GDP is just a summation of individual country specific GDPs; every country is planning and making policies for their growth only not of others. So cyclicality of global trade is influenced by business cycles of various economies especially the larger ones.
But the element of cyclicality is coming down in the global trade and there are some very interesting reasons for that. We will be amused to see the highly complex interplay of globalization and then de-globalization and economic growth dynamics. Let’s first see Global value Chains (GVCs)- GVCs are the outcome of international division of labour and specialization where entire manufacturing process of a product is divided/fragmented across economies to benefit from lower labour cost or expertise. So we can see this is the culmination of dream of economics for productivity. GVCs are the ones responsible for real globalization as many countries contributed in the production of a product. Before GVCs, products like cars, aeroplane, electronics etc were manufactured majorly at a single place and then they were supplied/exported out to the world. Like, take the case of mobile phone now, US does the designing (major part) and then processors and other components are manufactured by Asian countries like South Korea and Japan and then China finally does the assembly and also manufactured some parts.
GVCs are the ones responsible for the high growth in the GDP in the last 50 years. Because of GVCs, the share of global trade grow from 20% of the world GDP in 1970s to hit over 50% by 2010 and it is hovering around 48% after recent phase of natural slowdown in GVCs and also after Covid countries are recalibrating the supply chains plus recent bursts of protectionist measures, trade wars and tariffs etc. The global trade growth hit 2 times of global GDP growth after GVCs in 1990s while it was around 1 time earlier. But GVCs have real worth in the sense that they divert the production of various parts of a product to the specialists and thus reduce the cost of the production and plays a major role in the economic growth of countries across the globe. Developing and under-developed countries can still play a relevant role in the production process and it contributes big time in the their economic growth.
Sound economic theory and sense behind GVCs- Actually, if you ask me then GVCs were inevitable. They were a natural progression not some out of the box Idea. The idea is that- If I am producing some unique product and looking to sell that to you people then I can’t sell that unless you people have the money to buy them. And if you don’t have money then I have to make sure or devise ways so that you can make money or give/create something to offer me in exchange of my product. If I see you have something to produce something which can be useful to me then I will try that you produce that product. And if you can play a role in the production of my product then I can use that so as to produce more and broaden the reach of my product.
So if a car manufacturer in US or Germany in the 1970s-80s wanted to sell their cars across the globe when most of the global economies were under-developed then they needed to make sure that those economies have money to buy their cars and this was where GVCs emerged…out of the natural progression/motivation.
And if we can see then the same premise still holds even when major economies like US are trying to impose tariffs. I can’t expect to stop exports from country “A” thinking that they will buy my products but I need to remind myself that first they need money to buy my products. So for those who are afraid that we can really see de-globalization, they can feel relax because global trade is a Zero sum game and it is a game where there are all winners. We can see some attempts to take the production back to a country but it is not possible in today’s world. The products produced by GVCs are not routine low tech products but they are some of the most complex products where it is not possible for one country to make the same in entirety like Aeroplane, cars or phones. And if US really succeed in producing all Apple phones in US then they have to take wheat from some countries so that they can buy Apple from US otherwise this de-globalization won’t happen.
So as I said earlier, GVCs are not some pseudo-science but an outcome of economic sense…natural product and natural economic entities don’t need much outside interference unless outside forces create mess which requires cleansing. GVCs are a self-sustaining natural phenomenon and I really don’t see them going away. Current opposition to GVCs and shouts of full local production is purely due to Geo-politics not economic sense.
Here want to add something on current shouts of de-globalization and impositions of tariffs due to trade imbalance. We hear all the time when US says that they have huge trade imbalance with China ( India also) and when we look at the figures we started to believe they have some sense. But good thing is that they are not much sense. Actually our present methods of calculating trade figures are outdated (just like our methods to calculate Inflation and even GDP). Our current methods to calculated figures of trade between two countries are from the old times when countries were producing goods in entirety in their countries. But not anymore. Now when US imports mobile phones from China the Trade statistics captures the GROSS VALUE OF PHONES exported out of China (Manufacturing cost to China not the retail price in US). But China is not manufacturing all the components of these phones; in fact they are adding minimum value while maximum value is added by US itself in the form of services like design, technology and marketing/branding ; further many parts are imported by China from other countries like Japan, Korea, Taiwan etc. Had the Apple iPhone is manufactured completely in US then the parts supplied by Japan/Korea would have been counted as trade deficit from these countries not China. So if we include NET VALUE added by China then this trade deficit figure of US-China trade will be halved or may be even less. It is just that China is at the end of the supply chain.
GVCs helps multinationals in managing competition in local economies: If you don’t include me in the supply chain and instead you are selling the products at my place then I will also try to replicate the same success. So if you want me to stay silent then better option is to give me some role in the chain. The reason we don’t have major local Indian brands in household appliances like TVs, refrigerators, ACs or in mobile phones or laptops is that foreign brands have included Indian firms and capital in the supply chain though at low end but we are happy with that (I will explain this aspect in detail some other time).
Most important change that has taken place in the last 10-20 years is that developing economies no longer are the supply centers; they are now the biggest consumers of products produced by GVCs. Large economies like India and China are not a factor of production for Mobile phones, cars etc. but they are now the biggest customers of these products. And multinationals are competing with each other for the share of this market and hence it makes more sense now for multinational companies to have production facilities in these countries as it will save the cost plus they will be near to the place of demand and can better manage the entire supply chain.
Role of Digitalization and ICT and communication technologies: The main reason for the growth of GVCs was the emergence of highly efficient communication technologies and ICT. Trade liberalization was indeed the factor but communication tech was one of the main enabler. ICT and communication tech made it possible to manage the complex activities of GVCs over long distances. And if we can see the capabilities in communications and ICT have now grown even bigger….multi-fold in the last 10 years or so. Powerful smartphones, video conferencing, IOT, sensors and most importantly High-Performance Computing and big data along with innovations in blockchain, and artificial intelligence is going to revolutionize the whole process for better control, tracking and execution. So we don’t have any reason to believe that infrastructure wise there will be problems/bottlenecks which will hit the growth of GVCs fundamentally. It is in fact the reverse- technology wise we are just getting better.
GVCs are here to stay and less cyclicality of global trade
So GVCs were the real enablers of our so-called globalization and to do so investments were poured into manufacturing and value chains at gigantic scale by all the countries involved and if you ask me it is not possible to re-invest again in host countries at this scale…almost impossible and any attempt to significant decoupling will lead to huge wastage and misallocation of resources. Hence keeping in view the huge sunk costs, extremely tough to replicate the supporting infrastructure (like Power plants and Logistics not just new factories) it is not possible for some countries to have the resources to replicate these facilities and infrastructure from scratch. Still, diversification of GVCs is another issue where companies are looking to diversify their chains to withstand geopolitical and other issues hampering their operations like China who has built massive factories at huge scale with big state level subsidies in everything from land, finance and cheap power. But now all this has begun to become so big that it has distorted the trade balance of China with everyone and it is not sustainable so rightfully these countries are looking to diversify with other countries like India, Indonesia where they can get better trade deals. So China may be facing huge troubles because of these massive factories since they were focussed on exports which China can hardly control especially in the current global scenario where countries are looking to cut manipulated trade partners.
But this diversification is more in the form of reshoring and regionalization which is in response to lower the risks like geopolitical, supply chain and concentration risk (and due to trade deals which we are seeing more and more now) where we have more than one supply chains (regional) rather than one single global chain. With one single global GVCs we have big benefit in the form of economies of scale (reason China built huge factories) but then we have risks of higher lead time, higher logistics cost (large ships looking for economies of scale is easier in theory), lesser reliability. So these regional GVCs are not about low cost product but about other more important factors like economic security and supply chain resilience. So, MNCs need to take this call based on factors explained above like Apple understands that due to trade war between UA and China it needs to expand its manufacturing base to other economies like India when India itself has become huge demand centre for Apple products.
And one important factor here with the trend of regionalization is the growth of small ships. We were made to believe that larger gigantic ships were the future of shipping due to economy of scale but business is never that simple. Economy of scale means filling the ships up to some 80% and then the fixed cost factor, huge upfront capital investments, requirement of massive investments in port infrastructure to handle these giants and then the need to maintain that costly infrastructure, then the huge pollution impact of these ships; so all these factors means the theory never worked fully. So present times, we all of a sudden find that for today’s world small ships are much better options-if we take into account lower costs, their capability to navigate small ports worldwide, requirement of much lower investments into costly port infrastructure, their flexibility in shifting to alternate fuels to lower the pollution, lower upfront costs. So this should benefit countries like India which are beginning to invest bigger in enhancing national shipping capacity. We will see the likes of GE Shipping and Shipping corp of India (SCI) buying more and more small ships. This will also help Indian shipping yard in the production of small ships where they have more skill and efficiency.
Container shipping and Bulk shipping: And another factor which will impact the global shipping is that GVCs slowdown/maturation will impact the container shipping more as they are required to restructure and shuffle their shipping stock and routes. Bulk trade (Crude oil, refined oil, dry bulk like iron, grains etc.) is not going to see much impact because these are the raw materials for various industries or are consumed as such. Container shipping also won’t see much impact in the medium term but it is just that in the short term they need the realignment and this is where Indian Shipping companies like GE Shipping and SCI can benefit. Right now their core business is dry bulk which is going to be stable and these two are also planning to invest big for container shipping. SCI has much elaborate plans right now with Indian Govt working on to develop bigger global scale shipping firms in India and they are investing in SCI to acquire ships and form trade agreements/joint ventures with Indian global industrial giants for shipping of their raw material and final products world-wide.
GE shipping has cash/investments of around Rs. 8000 cr against market capitalization of Rs. 14000 cr and market somehow doesn’t give any value for the earning potential of this cash in the books. For long it is the belief that GE management is very conservative and they won’t be using this amount for expansion so market never assign any PE multiple for this cash in the books. Although GE has time and again demonstrated their strategic use of this cash because they used this amount to buy new ships in slowdown period cheaply and later on they sell during the high tide period. But that was when the cash in books was not that significant figure- as a proportion of market value or individually or net of debt. Till 2022 the cash in their books was always around 3000 cr and their debt was always higher than this figure (around Rs. 5000 cr to 6000 cr). So at net level they were never debt free; which means they were basically using low interest rate debt against their strategic planning of buying ships cheaply in slack period and make much higher than the cost of debt. But now the situation is quite different- Their debt is just Rs. 1200 cr against cash in the books of Rs. 8000 cr. So in my view, GE Shipping management is going to take a big call with this money- either the expansion into container shipping where we don’t have anything from Indian side or expansion into port infrastructure or buying more tanker/dry bulk ships (depending on price and Indian Govt push).
So where global trade stands- Global trade is a replica of Global GDP but this relationship was not linear for the past 30 years or so because global trade was growing at double the pace of global GDP growth and this was due to emergence of GVCs which resulted in the progression of more trade between various nations for products which were produced mostly inside a single economy earlier. So even for same level of consumption/revenue the trade between various nation was increased and when we accounted for resultant GDP growth because of these GVCs the impact on the global trade was huge. So for a long time till 2018-19 global trade was growing much higher than the global GDP growth. And this if we can see was one reason for the variation in the demand supply patterns of global shipping because alongside growth of GVCs huge investments were required for shipping also and we can also see the reason for intermediate crisis in global shipping like in 2008 crisis when global shipping was hit much harder than the global GDP precisely because of these reasons.
GVCs now have entered a phase of maturation and coupled with the emergence of various protectionist policies the growth rate of GVCs is slowing down and due to this global trade is also now growing one to one with global GDP growth. But if we can see the most important factor- earlier growth was there but there was always a possibility of growth slowing down due to perceived geopolitical and economic reasons so market was always trying to guess/assess the coming slowdown in shipping which did arrive but very late. And now with the maturation of GVCs this perceived cyclicality is going to come down.
Most importantly- Shipping is a global business affected mostly by global factors not country specific. Global GDP is different from GDP of a country. Many times due to global factors (like diversification of GVCs) Local GDPs may fluctuate but at global scale the global GDP may not fluctuate because the demand supply entities from that economy may shift to another economy (like from China to India). So local GDPs may fall but global GDP may still see growth and global shipping rates are governed by global GDP growth not local ones. So if GDP of China falls due to trade shifting to India then global GDP will stay the same and so even with fall in Chin GDP there is no effect on shipping demand. In fact all this diversification of GVCs should take care of any expected futuristic probable fluctuations in global trade and any perceived cyclicality of global trade. So if diversified GVCs are going to lower the cyclicality of global trade which as of now is anticipated all the time by Market due to which market does not assign higher price multiple to earnings of shipping business (lower PE because market feels these earnings are not stable and will see cycles), this should re-rate the price multiple to the extent of lower cyclicality.
Part C: Quick review and analysis of some other critical topics
In part C, I am covering a quick analysis of some other critical topics. These topics are vast and require separate detailed studies. So we will cover them in full details in the next part of the series but since these are essential for a comprehensive understanding of current state of global shipping so I am sharing the quick review of these topics. The topics covered here are:
a) What really ails global shipping business- Why Global shipping margins are always under pressure with high variability?
b) Whether we need to review ROE of shipping business and a consequent revision in Price Multiple?
c) Ships are a separate asset class
a) What really ails global shipping business- Why Global shipping margins are always under pressure with high variability?
If we look at it fundamentally then there should be no business like shipping- global appeal and scale, very high entry barriers, strong correlation with global economics (individual countries may face tough economic conditions but globally GDP growth is quite stable), no substitute, shipping cost being very small portion of total value of goods shipped etc. But still, quite ironically it is considered as one being very risky, command low price valuation multiples and freight rates are quite erratic and moves in cycles which are very hard to predict which makes very tough to strategize investments in new ships and capacities. So what really is happening here?
Global shipping is different from manufacturing sector where raw material cost and final product price are most relevant factors and in most of the industries both raw material and final product can be shipped anywhere from the globe. So these are very complex industries shaped by RAW MATERIAL and FINAL PRODUCT. But shipping has no raw material and is dictated by one factor-Supply demand equation of Ships. In 1960s we have the growth boom from Europe and Japan resulting in huge demand for Shipping and huge growth. This was then followed by global economic problems of 1970s and 80s where supply of ships was way higher than the demand which persisted till 2000s for various reasons. During this phase there was hardly any new supply and then all of a sudden China happened and then the growth of BRICS and this coupled with low new supply of ships created a scenario where prices of new ships grew 6-7 times in the matter of 5-6 years till 2007-08. Old ships were all of a sudden were pure gold. And then Financial crisis happened in 2008 and we had the same old problem- Supply way higher than demand. We can see where we stand now as far as new shipping capacity in the last 10 years or so.
Most important factor- Large shipping firms were buying giant ships after 2010 which had the stunning economies of scale. They were thinking that they will hit the small players (Family owned firms having small ships) out of the market and then they will capture the market and all great. But they ignored the threat of Third Party Logistics (3PL) in shipping. 3PL players were allowed to integrate the fragmented small ships owners and by integrating them they have created a HUGE VIRTUAL LARGE SHIPPING Firm with huge number of vessels collectively large enough to hit the Shipping Giants. Plus these 3PL players also controlled the most valuable data which is generated while they interact with large number of customers scattered worldwide. So 3PL players generated and controlled vast amount of data related to shipping routes, volumes/inventory, delays, demand pattern etc. 3PLs use this massive historical data in their algorithms to assess delays, demand supply variables, supply chain problems etc so all this helped them to serve better. Most importantly, 3PL reduced the shipping companies as just last mile asset supplier while 3PL owns everything from data to supply chain and they further offered last mile delivery by integrating Warehouse Management Systems (WMS) and Transportation Management Systems (TMS) and they become a complete solution providers to the customers. And with this they broke the most important growth factor for Shipping firms- NETWORKING EFFECTS.
(This section about fundamental problems faced by shipping sector is the most critical part of the study and will take up the same in the future. This small note on it was just for introduction)
b) Whether we need to review ROE of shipping business and a consequent revision in Price Multiple
Return over Equity (ROE) is the most complex and misused thing in the financial world…just like Price to Earning ratio (PE ratio). There is nothing complex about the formula derivation of these ratios; it is the interpretation, implementation and understanding as to how much is “how much”. But we do have some linear benchmarks like higher the ROE better the financial and operating metrics of that firm and so we find that stock market rewards and valued high ROE firms like FMCG, Software, Pharma etc. handsomely. These are the firms with high PE ratio because of their superior ROE. But things are never as straightforward as it seems in investment world. Routine theory says that Intellectual property (IP) led firms like firms having strong brands, patents, software products, monopoly rights etc deserve very high valuation multiples (PE ratio) and on the similar lines commodity/cyclical stocks should get lower multiples. Reason- superior ROE of IP led firms.
But this superior ROE is not really that superior for IP firms. This is primarily due to absence of valuation of intangibles in their balance sheet- these firms derive their superior topline and bottom-line due to the presence/enjoyment of Intangibles assets but due to our current accounting standards these are not assigned any value in the balance sheets or if they do assign some value the same is way lower than the market value because the same is shown at cost in the balance sheet. Like, for a pharma company doing path breaking research on new cancer molecule the cost of research is booked as expense as long as the same does not deliver any successful/marketable results. Say a pharma firm has spent Rs. 5000 cr for research into 5 molecules with no success so all this cost will be booked into the P&L statement as an expense; it is expensed out. And then finally their Rs. 1000 cr research for the sixth molecule hit the success and they can market this molecule. Now as per the standards they can show this Rs. 1000 cr as an intangible asset. However the market value of this molecule may be around Rs. 30000 cr because of huge revenue potential and they will be making around Rs. 1000 net profit each year. But here, stock market won’t follow accounting standard and it will value the said firm at Rs. 50000 cr (50 PE) and we can see they are giving the intangibles their true value which is fair enough.
So if we can see, we as stock investor are really paying the price of the intangible and firm is valued at Rs. 50k cr while its net-worth/book value will be around Rs. 3000 cr. But when we calculate ROE, we will say that ROE is 33% (1000 cr NP/3000 cr Net-worth) which looks great. But just add the value of intangibles we are really paying and things will look quite different. This ratio is called earning Yield and I am much more comfortable in using this ratio for these types of stocks because it will reveal the relative position of the competition (other stocks). Like for this firm making Rs. 1000 cr Net profit on Rs. 50000 cr market value, the earning yield is just 2%; even if we value it more conservatively at 20 PE the earning yield will still be around 5%. So the higher PE ratio we see in these stocks is not due to superior ROE but due to valuation of intangibles which do have huge value. The intangibles have value because they act as a huge entry barrier factor apart from their operational value. It is just like a Hotel stock which owns the land (purchased 40 years ago) and the building itself. So the valuation of land in the books will be very less (they can revalue it but keeping in view the regular costs for the same and resultant impact on return ratios most hotels/businesses don’t do it) but stock market will value it for the same in the form of very high PE.
On the other hand, in case of cyclical stocks like Shipping or steel every asset and resource is fully captured in the balance sheet reflecting reasonably fair valuation. Also, many times lower returns act as a big entry barrier.
Most people think that cyclical businesses like Shipping or steel have low entry barriers. But it is not the case as the need is to look at this from another perspective or angle. The biggest entry barrier point in cyclical business is the capital. Or we can better say Debt because the level of capital is related to debt availability for cyclical business. So in my view, debt availability is the biggest entry barrier factor in cyclical business because banks/lenders cannot lend to all i.e. they can’t lend to new competitors as the same will create risk for their earlier debt given for earlier assets. And if businessmen try to bring most of their own capital in these cyclical businesses then this will hit the ROE relative to risks they are taking and this will make the entire business case very less attractive and risky. IP led stocks like pharma or software reply mostly on equity funding during R&D or product development stage because this may not yield success hence only equity funding can bear this risk not debt. So for Cyclical stocks, the best way to shore up the ROE is by using debt judiciously (first rule is not to take high cost debt in boom times, always look out for debt in lean period and pay back the significant portion with high profits during boom period…boom period is not for building excess capacity).
Role of banks/lenders is crucial here. Take the case of Steel- Say India’s total steel production capacity is 200 Million Tonnes with actual production around 150 Million Tonnes and keeping in view the future demand scenario banks should be able to assess if it is justifiable to give big loan for another 50 MT capacity expansion that too by new players. So lending is not one dimensional exercise as is being treated right now and it has huge scope for AI/Analytical automation if they can’t create professional and technical teams to assess these risks.
Hence, there is a need to review the impact of ROE taken into consideration while deciding/assigning valuation multiples to cyclical businesses especially to Shipping.
(So, as shared above I am leaving this aspect for now. I will pick this in more detail in future studies).
c) Ships are a separate asset class
Diversification in various asset classes is the holy grail of risk mitigation in investment world. The motive is to find assets with no or lesser correlation which is done by targeting assets with different economic cycles, industries, and geographic markets. To mitigate the risk of a particular economy, we can look at many other economies for investment but there is a limit to that. But then we have shipping which is a global business affected mainly by global factors not country specific. So Ships offer exposure to different business cycles and economic variables not covered by other assets like Real estate, gold or stocks. So with Ships investors get an exposure to the global economy which is not covered by any other asset class and shipping is affected by quite a broader range of economic variables as compared to other asset classes like real estate or stocks which are mostly affected by narrow local factors. Most important factor- The economic variables which affect shipping are generally very different from factors affecting real estate or stocks like global commodity cycles, shifts in global trade, shipping rates fluctuation due to seasonality and shipping routes etc. So they are a perfect diversification with very good earning yield potential. Further, recently the Ship Tokenization has made investment in Shipping highly liquid as by dividing the value of a ship into digital tokens investors can sell these ship shares in the secondary market just like we trade stocks. Though returns are different in owning ship tokens vs owning shipping companies stocks due to factors like corporate overheads, interest costs etc. in the case of general shipping stocks. Shipping stocks are already a highly liquid asset class.
I am closing this study for now. Shipping is a way complex business and present study was the first part in this endeavour although we have covered most critical factors already in this study.
(Disclaimer: The above study is purely an educational content and is only for learning purposes. The Writer is a SEBI Registered Investment advisor (SEBI IA registration Number INA000020244) and the stocks discussed in this study are held by him in his personal capacity as well as by his clients. The above study is based on personal opinions and analysis. Please do not consider this study as an investment advice for investment in the stocks discussed in the above study and do your due diligence or consult a certified financial advisor before investing into these stocks. The content writer shall not be held responsible for any profits or losses incurred as a result of investment decisions made by readers based on the shared content).